This blog post will be highlighting how I think about Government Bonds and my approach in thinking about them. The previous post was an introduction into what Government Bonds are, some key information as to how they work and some of the risks associated with investing in them.

When I think about Government Bonds I always link it to how much yield I am getting above inflation. The difference between the nominal yield and inflation is called the real yield. It is the increase in purchasing power you should be getting on your investment. A simple rule that I always use when thinking about where to invest my money is how much return am I getting above inflation, as I am interested in growing my purchasing power over time. I will clarify this concept with a simple example.

Imagine you had R100.00 and you had 2 options, either invest the money or use it now and buy a set of earphones (assuming you can get a pair of earphones for R100.00). Now let’s assume inflation is 5% per annum and a Bank Savings Deposit offers you 4% interest per annum. In a year’s time, you will have R104.00 in your Bank account but now, the earphones cost R105.00. You cannot afford the earphones, which is a shame because a year ago you could afford them. This is an example of a loss of purchasing power. Your investment did not beat inflation and you cannot afford to buy goods and services that you were able to afford a year ago. This is why I always aim for a real yield that is positive and not negative.

Now, coming back to the SA Government Bonds…

The reason why I still like buying Government Bonds is because the current real yield on SA Government Bonds is really high, relative to its own history. The current SA 10 Year real yield is 6%, and from the chart below, you can see that the yield has not been this high for almost 20 years, at least not for long enough time periods. South Africa’s nominal yields reached levels close to 20% during the late 1990’s as the Asia crisis occurred and sent ripples of fear into Emerging market currencies and Interest rates. So I’m getting a pretty good yield on SA Government debt since the yield hasn’t been this high in a while.

I’m also a big fan of Bonds at the moment because of the inflationary environment. Inflation is coming in pretty low, and without much pressure in the near term. This is positive for bonds because the real yield you get is quite high. With inflation being low, the real yield on SA ALBI Bond Index is close to 6% currently, which is also high relative to history. Below is an image from the SARB’s Quarterly Bulletin (December Edition, 2020) and shows the inflation profile of South Africa over the past few years. In my view, we will stay at this level of inflation for the next couple of months, as the economy slowly gets back onto its feet.

Market participants are also expecting inflation to remain close to 4.5% over the medium term. Below is a table highlighting inflation expectations by different interest groups. Financial analysts are expecting an environment of inflation being lower than 4.5%, as do most groups besides Business representatives; they view it possibly a few basis points higher. Not a materially meaningful difference in my view. These are soft inflation expectations at best in my view.

Now don’t get me wrong, I do acknowledge that Government has a lot of debt on its books and the amount of money that needs to be dedicated to Eskom and the like is huge, but at these levels in interests rates, and given how low the Repo Rate is, this is a great opportunity to pick up high yield without taking on additional corporate risk.

Bank deposits at banks are offering very low rates and the chances of earning inflation beating interest is low, so Bonds win in that regard as well. The graph below shows Money market rates. This is what most Money Market Deposits at Banks offer to clients. The lower the Repurchase Rate (Repo Rate), the lower the interest clients can expected to be generated in their Savings accounts. This rate has gone from 8.5% down to around 4%, almost half of your expected returns has been wiped out.

Low inflation means high real yield and most market participants are expecting an inflation level of close to 4.5%. This should mean that with bonds even staying at 9.3%, we get a 5% real yield expected return, which is quite high.

Also, according to theory, a Government bond is the safest asset in a country given the fact that the Government can technically never run out of money. So you implicitly have the safest asset in South Africa offering the highest real yield it has in almost 20 years and is expected to maintain this level of return as long as inflation remains well behaved, and given the current environment, it is expected to.

To me, the easiest trade in the world.

This month’s learnings and insights section will be covering Government Bonds. It’s been an asset that I’ve been a fan of for a couple of years now given the current level of return one can receive on them. I’ll be splitting these posts into 3 parts. The first section will be a brief introduction as to what Government Bonds are, the second section will be a quick analysis and how I like to think about SA Bonds and the final section will include how I view them as an asset in my current mix of assets.

A reminder that this does not constitute as financial advice and all the views held are my own. This is simply my own views on SA Government Bonds and how I think about them.

1. What is a Government Bond?

A government bond is a type of debt-based investment, where you loan money to a government in return for an agreed rate of interest. Governments use them to raise funds that can be spent on new projects or infrastructure. When you buy a government bond, you lend the government an agreed amount of money for an agreed period of time. In return, the government will pay you back a set level of interest at regular periods, known as the coupon.

This is one of the advantages of owning Government Bonds, in that they have stable, predictable cash income. Once the bond expires, you’ll get back your original investment and final interest payment. The day on which you get your original investment back is called the maturity date. Different bonds will come with different maturity dates – you could buy a bond that matures in less than a year, or one that matures in 30 years or more. Just like shares, government bonds can be held as an investment or sold on to other traders on the open market.

The way in which you can access them is through either an ETF or a Unit trust. There are plenty of asset managers in the country that have Bond funds that can help you get this kind of exposure. These products are managed in such a way that there is no “maturity date” and these products can be held for many years. Instead of holding one type of Government Bond (one bond with a fixed maturity date), these funds are constructed in such a way that the investors will hold Government Bonds with different maturity dates and will always have exposure to Government debt.

You might hear investors say that a government bond is a risk-free investment. Since a government can always print more money to meet its debts, the theory goes, you’ll always get your money back when the bond matures. In reality, the picture is more complicated. Some Governments have defaulted on their debts and failed to meet their obligations to investors. In general, Government Bonds are looked as the safest asset due to the fact that the government will make the payments, even if it needs to hike taxes to collect more money to pay off its debts. That’s where the “safety” comes from.

2. What is Yield to Maturity?

The yield to maturity is the rate that your investment will yield over the life time of your Bond. There is an inverse relationship between a bond’s yield to maturity and the price. If the yield goes up, the price will go down and visa-versa. Various economical, internal and external factors e.g. the inflation rate, GDP, the currency etc. will influence the yield to maturity on a daily basis. High interest rates are usually indicative of investors finding something worrying in a country. There may be heightened political issues or tensions, a precarious budget deficit position or some other perceived riskiness in allocating money to the borrowing country.

There also tends to be a good correlation between a higher credit rating and lower interest rates. Countries that are perceived to be safer based off of certain credit metrics will pay lower interest rates on their Government Debt; whilst those that score negatively on these credit metrics tend to pay higher interest rates on their Government debt. Supply and Demand dynamics also have a significant impact on yields. If there is a large demand for Government Debt, then investors are willing to accept a lower return on their investment (i.e. they’ll charge a lower interest rate on the debt). The opposite is true when there is an oversupply of Government debt; the debt needs to be priced attractively enough for people to invest. (You’d loan them more money if you can receive a higher return for the level of risk you’re taking).

Below is an idea of the borrowing the South African Government + Public Corporations require for the next year. As you can see, the borrowing requirement has increased quite dramatically. The government now needs to borrow close to R200 billion for this year’s expenditures due to Covid lockdowns, fall in revenue collections and increased support required for the economy.

3. Key Risks

Aside from credit risk (the risk that the person/entity you’re lending to cannot pay you back), there are a few other potential pitfalls to watch out for with government bonds: including risk from interest rates, inflation and currencies.

Interest rate risk is the potential that rising interest rates will cause the value of your bond to fall. This risk is magnified by the Modified Duration of the bond. Modified Duration is the Bond’s sensitivity to changes in the interest rate. If the modified duration of a bond is high, then the impact of a change in interest rates is higher (if rates rise, the impact is negative, if rates fall, the duration impact is positive). Inflation risk is the potential that rising inflation will cause the value of your bond to fall. This is because with rising inflation, the real return on your Bond decreases. If the rate of inflation rises over the yield to maturity of your bond, then your investment will lose you money in real terms. Inflation-linked bonds can help mitigate this risk.

In summary, a Government Bond is a debt instrument that the Government uses to fund itself. As an investor, you’re able to invest in this (that is, you’re able to borrow Government money) and receive interest from them (called a coupon). What matters is inflation risk (how inflation ruins your purchasing power) and credit risk when thinking about Bonds as well as interest rate risk itself (how changes in interest rates affect the value of your bond; think about the inverse relationship mentioned earlier).

In part 2, I’ll be diving more into some analysis and how I like to think about SA Government Bonds…

Stay tuned